China restructuring

Preying on China’s distress — IFR Asia


Preying on China’s distress

IFR Asia 806 – July 27, 2013 | By Timothy Sifert

Global advisory firms are beginning to allocate more resources to China in a bet that slowing economic growth and tighter credit conditions will lead to a rise in restructuring opportunities.

Slowing growth and mounting debt burdens are creating an environment that is, in theory, ripe for turnaround specialists and distressed debt investors. A number have been adding senior staff in China, a market that remains largely untapped relative to the rest of Asia.

Investors, however, warn that restructuring specialists may find doing business in China a lot more difficult than they anticipated.

AlixPartners has doubled the size of its team in Asia to about 70 in the last two years. Alvarez & Marsal appointed Yansong Xue and Bing Liu as directors in Beijing this month. Both firms plan to continue expanding in China and elsewhere in Asia.

“Most of our work is done when you have a leveraged Chinese company with some kind of private-equity firm backing it and it’s in default,” said Ivo Naumann, managing director, AlixPartners, Shanghai. “We are engaged by equity owners and creditors to help with leadership in the process, and are often brought in as an interim manager.”

Turnaround shops, however, are also targeting the underperforming China operations of multinational corporations.

“For many Western companies, five or 10 years ago, you just had to be in China irrespective of profitability, and that was fine when you were making a lot of money in Europe and the US, but it’s not working now,” Naumann said.

Chinese growth has slowed in nine of the past 10 quarters, and data last week showed that the country’s production lost momentum for the third straight month.

At the same time, companies are facing a tougher time accessing financing as regulators force banks to reform their risk management and rein in off-balance-sheet lending. A liquidity squeeze in China’s money markets has pushed up the cost of bonds, and no domestic IPO has priced since October 2012.

Refinancing pressures in China have rarely led to the kind of restructuring or turnaround opportunities that are common in the US and Europe. No domestic bond issue has defaulted, while local politics and laws related to restructuring have often frustrated international investors, adding to general linguistic and cultural differences.

Advisers, however, believe the renewed focus on reform under Premier Li Keqiang will lead to more opportunities for conventional workouts.

Predator and saviour

Many on China’s long list of PE-backed companies are already feeling the pressure, they say.

Over the past decade, the market for Chinese PE has grown rapidly, only to decrease just as rapidly as the local PE markets offered few exit opportunities. PE investments in China are on pace to reach US$6.4bn for the full year 2013 – that is a 64.2% decline from the 2011 peak. (See Chart.)

This ebb in new investments means fund managers are spending more time on existing portfolios.

“[R]unning a private equity fund has become much more of a value-add business in that funds now have to manage their portfolio companies,” said Oliver Stratton, co-head of Alvarez & Marsal Asia, a turnaround firm. “They’re not only investors, and they can’t be passive. So, they’re thinking, ‘we actually have to grow earnings now and fix up the balance sheet’.”

What is more, foreign firms have not always committed the necessary local resources – or had the patience – to address the full scope of the market. The effect is a missed business opportunity.

“Broadly speaking, there is an almost-unimaginably huge money-making opportunity available for turnaround/restructuring firms to act as predator and saviour for PE portfolios in China,” said Peter Fuhrman, chairman and CEO of China First Capital, an international investment bank focusing on China.

“But – and it’s a very big but – there really are few if any firms with that capability, experience, focus. It is, therefore, a great example of why often the best and easiest opportunities to make money in China are overlooked or not acted upon.”

Meanwhile, in part because China’s bank loan market is opaque, potential investors have had to go to greater lengths to get basic information on local assets. On a few occasions, investors have called on risk consultancies to vet PRC loans and the parties backing them.

“We don’t help clients source investments, but we see growing demand to investigate non-performing loans in China,” said Tadashi Kageyama, senior managing director at Kroll Advisory Solutions in Hong Kong. “Interest in these assets should grow after the liquidity squeeze this year.”

Out of court

The Chinese court system, and the way it deals with bankruptcy, can be both a benefit and a hurdle to restructurings. Turnaround specialists said that judges were often quick to liquidate a defaulted firm, rather than engage in a lengthier workout process that could have benefits for debtors and creditors.

“China has a modern bankruptcy code that’s fine and as good as in Europe,” said AlixPartners’ Naumann. “It’s just that the courts and creditors have limited experience in executing it. Their intentions are good, but, in mainland China, a judge’s performance is often measured by the number of cases decided. So, for a judge to engage in a lengthy and highly complex turnaround process, it is challenging. This may sometimes lead to a situation where a liquidation is given priority over a turnaround process.”

As a result, sources said, PE-backed companies – their managers, debtors and creditors – often wanted to settle things out of court. That is where restructuring firms can come in to turn things around.

Yet, to be a relative success in this market is probably going to take a bigger commitment than firms have demonstrated in the recent past. Not a lot of money has been made in China restructuring relative to the rest of the world, sources say.

“It is not particularly difficult for foreign or domestic firms to make money in China, but why no turnaround firms? It starts from simple, humble, unsexy things like none of these guys have real offices in China with significant Chinese-speaking teams with experience in fixing what’s broken inside a Chinese company,” CFC’s Fuhrman said. “They will quickly gravitate to better-paying jobs in PE or investment banking.

“Without teams, you can’t do squat.”


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China Investment Banking Case Study: An SOE Privatization

China First Capital Signing ceremony

Anyone who’s dipped into this blog will know that I rarely, if ever, discuss directly what me and my company China First Capital do, our client work. Partly it’s because the work is usually by necessity confidential (clients, investors, deal terms) and partly because I don’t blog as a marketing tool.

But, I plan over coming months to share significant details about a “live deal” we are now working on, a buyout transaction involving a Chinese state-owned enterprise (SOE). The reasons: its size and structure make it an unusual transaction in China, and one that might also bust some myths about the way business in China, especially involving SOEs, actually works.

While I can’t reveal the name of the company, I can disclose why I think it’s such a compelling deal.  Our client is one of China’s largest, most well-known and most successful SOEs. The group’s overall annual profit of over Rmb12 bn (about USD$2bn) also make it one of the richest. Unlike a lot of SOEs, this one operates in highly-competitive markets, and has nothing like a monopoly in China.

The deal we’re working on is to restructure then “privatize” two profitable subsidiary companies of this SOE. Both of these subsidiaries are the largest businesses in China in their industry. Their combined revenues are about $220mn.

Privatization has two slightly different meanings in Chinese finance. First, is the type of deal, very common a decade ago, where big SOEs like China Mobile, Sinopec, PetroChina, ICBC, Air China, are converted into joint stock companies and then a minority share is listed through an IPO on stock markets in China, US or Hong Kong. The companies’ majority owner remains the Chinese state, with the shares usually held and managed by a powerful arm of the government known in Chinese as 国资委, in English known as the State-owned Assets Supervision and Administration Commission, or more commonly SASAC. In theory, SASAC probably holds the world’s largest and most valuable share portfolio, far bigger than Fidelity,  Vanguard, or the world’s sovereign wealth funds.

The other, rarer,  type of privatization is where a company’s majority ownership changes hands, from state to private ownership. This is the type of control deal we are working on. The plan is to spin out the two subsidiaries by selling a majority stake to either a strategic or financial acquirer. In all likelihood, each company will one day go public either in China or Hong Kong, at which time, I’d expect their market caps to each be well over US$1bn.

In essence, the deals are structured as a recapitalization, where a new private-sector majority owner will contribute capital in excess of the company’s current assessed value. That valuation is determined by an independent accounting firm,  based on current asset value.

The privatization process is heavily regulated and tightly controlled by SASAC. It involves multiple levels of review, outside valuation, and then an open-market auction process. The system has changed out of all recognition from the first generation of government asset sales done in the 1990s. These deals involved little to no public disclosure or transparency and generated quite a lot of criticism and resentment that Chinese state assets were being sold to insiders, or the well-connected, for a fraction of their true value.

For an investment bank, working with an SOE, especially a large and famous one, has a process, logic and rhythm all its own. There are many more layers of management than at a typical Chinese private company, and many more voices involved in decision-making. In this case, we’re rather fortunate that the chairman of the holding company is also the founder of the two subsidiaries we’re now seeking to spin out. He started the companies from zero less than ten years ago, and has built them into proud, successful, fast-growing businesses.

This chairman has far more sway over the strategy and direction of the SOE than is usual in China. I first met him over a year ago. I was called to visit the company to explain the process through which an SOE like his could raise outside capital. Though curious, the chairman said at the time it seemed like more trouble than it would be worth. He had a comfortable life, and was nearing mandatory retirement age.

In fact, as I now understand, that first meeting was really just a way to kickstart a long, complicated and confidential discussion process involving the chairman, his senior management team, as well as even more senior officials at the SOE.  Over the course of a year, the chairman was able to persuade himself, as well as the many others with a potential veto, that a spin-out of the two companies was worth considering in greater detail.

The privatization offers the promise of long-term access to capital and also, most likely, a greater degree of management autonomy.  Though the two subsidiaries do not sell to, rely on or otherwise have related party transactions with the parent, they are ultimately subject to some rather heavy and often-stifling bureaucratic controls. Contrary to the reputation of many Chinese SOE, the two companies sell high-end products to large fastidious global customers. They operate in highly kinetic markets but with a corporate structure above them that is as slow, ponderous and impenetrable as a five-hour Peking Opera performance.

The chairman invited me to return for another visit in June. What followed was a rather intensive process of me and my team submitting several different financing plans and options, including the privatization of either the whole holding company or various subsidiaries, either as standalones, or grouped into mini-conglomerates. These different plans got discussed very actively inside the SOE. In under a month, the company had decided how it wanted to proceed: that its two strongest and most successful subsidiaries should be separately spun off and majority control in each offered to a new investor.

It may not sound like it, but one month is a remarkably fast time for an SOE to consider, decide and then get necessary approvals to do just about anything. We also work with another even larger Beijing-headquartered SOE and it took them almost four months to get the eleven different people needed to approve, and apply the chop to, our template Non-Disclosure Agreement.

I was summoned with one day’s advance notice to return to the company in late July to sign a cooperation agreement to advise them on the proposed privatization/recapitalization of the two subsidiaries. Again, that’s rather typical of SOEs:  meetings are called suddenly, and one needs to drop whatever one’s doing and attend. For me, that meant a hastily-booked two hour flight, then a three-and-a-half hour drive to the company’s headquarters. A photo from the signing ceremony is at the top of this page. (I have to cover over the name of the company.)

The contract signing was followed by another in a series of very elaborate and extremely tasty meals. The chairman has converted a 13-acre plot of the company’s land into an organic farm, where he grows fruits and vegetables and raises free-range pigs, ducks, chickens. Everything I’ve eaten while visiting the company has come from this farm. Everything is remarkably good. And, yes, along with the food, a rather large amount of Chinese alcohol is poured.

In future posts, I’ll talk about different aspects of the transaction, including how to parse the balance sheet and P&L of an SOE, as well as the industrial and investment logic of doing a takeover of an SOE. In the current market environment in China, where so many PE minority investments are stranded with no means to exit, there has probably never been a better time to do buyout transactions, particularly of mature and successful industrial companies with scale, good profit margins and clean accounting. Good businesses like this are few. We are now working for two of them.